What is Your Biggest Financial Risk? | White Coat Investor

There are a lot of financial risks in your life. I frequently run into people who are worried about the wrong ones though. They seem to have little insight into what their biggest risks are. Our biggest financial risk frequently changes as we move throughout life and I think it is important to recognize and protect yourself against your biggest risks. Here are some of the financial risks that you might run at some point during your life:

1. Market risk
2. Interest rate risk
3. Inflation risk
4. Risk of running out of money due to inadequate returns
5. Risk of disability
6. Risk of death
7. Leverage risk
8. Small business/entrepreneur risk

Now let’s go through a few scenarios. We’ll first list the risks that person is running, and then identify the largest risks and how to protect against them.

Scenario One: A Recent Retiree

Jill recently became financially independent and retired. She is 68 years old, single, and has her home paid off. She has a $1.5 Million portfolio invested entirely in stocks with a sizeable small value tilt, is receiving $25K/year from Social Security, and spends $85K/year. Which of these risks is she running?

1. Market risk
2. Interest rate risk
3. Inflation risk
4. Risk of running out of money due to inadequate returns
5. Risk of disability
6. Risk of death
7. Leverage risk
8. Small business/entrepreneur risk
   

Market Risk

In this carefully crafted scenario, she is really quite protected from most of these risks. Given her aggressive portfolio, her returns are likely to be adequate to keep up with inflation and provide enough of a return to support a 4% withdrawal rate. She does face serious market risk, however. In a bear market, she could lose 50% or more of her portfolio. That would introduce sequence of returns risk and could possibly even cause her to panic and sell low, a real tragedy.

Protection Measures

She could protect herself from this risk by dialing back the portfolio risk a bit. She could have a less severe factor tilt, add some bonds or cash to the portfolio, and maybe even diversify a bit into real estate or protect against an isolated stock downturn and improve income. Yes, this will increase her inflation risk and risk of running out of money somewhat, but a more balanced approach between her risks is likely indicated.

Scenario Two: The Scaredy Cat Retirees

Jose and Isabella also recently retired. They are 63 years old, have no debt, and are already collecting both of their Social Security checks for a total of $35K/year. They spend $90K per year and have a $1 Million portfolio invested in a combination of nominal bond funds and CDs. Which risks are they running?

1. Market risk
2. Interest rate risk
3. Inflation risk
4. Risk of running out of money due to inadequate returns
5. Risk of disability
6. Risk of death
7. Leverage risk
8. Small business/entrepreneur risk

Inflation Risk/Running Out of Money

This couple has serious exposure to inflation risk. Just a few years of double digit inflation would seriously erode their asset base. Their only protection against inflation is the Social Security adjustment they would see each year. Perhaps more significantly, they have a portfolio with a nominal yield of something like 2-3% but are withdrawing $90K-$35K = $65K/$1M = 6.5% per year. Even if inflation were 0%, which it almost surely will not be, they will drain their entire portfolio at some point in their 80s and be living on just Social Security.

Protection Measures

• The most reliable protection is to simply spend less money. This will dramatically reduce the risk of running out of money.
• In addition, if they would run even a little bit of market risk (perhaps increasing the portion of the portfolio dedicated to risky assets such as stocks and real estate to 25-50%), they would further reduce that risk and protect themselves against inflation.
• Swapping out some of the nominal bonds/CDs for TIPS would also provide some inflation protection. There are other alternatives too.
• They could purchase a Single Premium Immediate Annuity (SPIA) to protect against running out of money, although it wouldn’t do much for inflation risk.
• They could also use some of their home equity to support their lifestyle. They could do this most simply (but not necessarily most easily) by downsizing and investing the recaptured home equity.
• They could also run some leverage risk by taking out a mortgage or HELOC and investing the freed-up assets in hopes of earning a higher rate than the mortgage.
• A reverse mortgage may also be an option, although it comes with serious downsides and additional risks, (at least to any potential heirs!)

Scenario Three: The Young Dentist

Lavar is a young dentist, fresh out of school, with 3 kids and a stay at home wife. He has a $500K student loan burden (refinanced to a variable 5.4% on a 15-year term), a $500K mortgage (fixed at 4.5%), and a $500K practice loan (variable 10-year loan at 5%). He made $150K last year and hopes to break $200K this year. He has not purchased any disability or life insurance because they are struggling to support their lifestyle while covering all of the debt payments. There is no portfolio yet either, but his employees are bugging him about putting a retirement plan in at the practice. What risks is he running?

1. Market risk
2. Interest rate risk
3. Inflation risk
4. Risk of running out of money due to inadequate returns
5. Risk of disability
6. Risk of death
7. Leverage risk
8. Small business/entrepreneur risk

Risk of Disability

As you can see, Lavar is running a ton of risk in his life. The biggest risks for him and his family, however, are his death and disability. His ability to earn a living is his greatest asset and it is completely unprotected. Luckily, if he is healthy, this problem is easily solved with some simple disability and life insurance. Yes, that is going to cost him some money, but frankly, he can’t afford not to have this insurance at this time in his life. Even if it means putting off investing or debt payoff, these insurances are absolutely critical for him and his family.

Leverage Risk

He is also running pretty massive leverage risk. He owes 10X his income. To make matters worse, 2/3 of this debt is exposed to interest rate risk. While I am often an advocate of running interest rate risk yourself when you can afford to do so (i.e. refinancing student loans to a 5-year variable rate when you’re planning to pay them off in 2 or 3 years), it does not appear to me at all that Lavar can afford to do so. In addition to all of this, Lavar is struggling to get this practice going. He lies awake at night wondering if he is going to be able to make payroll each month. He has serious small business risk as well.

Protection Measures

Perhaps the best solution for Lavar and his family at this time is to get very hardcore about personal finance. He needs to boost income and cut spending and get himself some breathing room. Any spending he does should be business spending directly aimed at increasing income through marketing or developing new skills, products, and services. Perhaps salaries at the practice can be cut in the short term by changing contracts to increase profit-sharing or even equity in hopes of improving cash flow now. While the debts can be restructured (and made fixed or even longer-term) if he can double or triple his income they all become much more manageable. If his practice is nowhere near full, perhaps he can even do some moonlighting as an associate for a while to increase income.

Scenario Four: The Physician Real Estate Guy

Patrick is a single hospital employee nephrologist ($240K income) a few years out of residency who really got into real estate investing recently. He has no disability insurance. He has refinanced his $250K in student loans to 3.5% fixed but doesn’t want to pay them off any faster than he has to in order to be able to invest more. He has about $50K in a 401(k). He recently moved into a duplex he bought and is renting out the other side. In the last year, he has closed on two other properties. One of these properties he used to live in and bought with a physician mortgage with 5% down. The mortgage is less than the rent, but for some reason, something seems to come up every month and he is cash flow negative on the property. The other property is a fixer-upper that he hopes to get a renter into soon. What risks is Patrick running?

1. Market risk
2. Interest rate risk
3. Inflation risk
4. Risk of running out of money due to inadequate returns
5. Risk of disability
6. Risk of death
7. Leverage risk
8. Small business/entrepreneur risk

Patrick has three main risks to be concerned about.

Market Risk

He has some market risk as the real estate market could turn on him. Property values could plummet and rents could even drop and maybe he won’t even be able to find a good tenant for the fixer-upper. He worries a lot about that risk, but in reality, his other two risks are far larger.

Risk of Disability

He should get disability insurance ASAP as his ability work clinically is still his greatest asset and is holding the whole house of cards together.

Leverage Risk

He is also massively overleveraged. He owes hundreds of thousands of dollars. He doesn’t have a single cash-flow positive property helping him pay the bills. Getting on top of his cash flow situation and debt to income ratio needs to be a big priority.

Protection Measures

When you find yourself in a big hole, step one is to stop digging. He needs to stop buying properties with money he doesn’t have to impress people he doesn’t even like. He needs to take a deep breath and slow this real estate train down. It isn’t that real estate is a bad investment. It isn’t even that these are bad properties. But the method and timing of his purchases are putting his whole financial life at risk. When real estate investors go broke, it is usually like this. Add a couple more cash flow negative properties into the mix or have even a minor hiccup in the real estate markets and it all collapses.

Perhaps one solution is to get this fixer-upper done and flip it. Maybe he makes some money, but if nothing else he reduces his debt to income ratio. He might also want to sell his old home if he isn’t too far underwater on it. He simply needs a stronger base with which to build his empire. Putting 25-25% down on these properties likely turns them into assets putting money into his pockets every month instead of liabilities taking money out.

A more minor point, but his real estate to stock ratio is awfully high and he may be missing out on a lot of the tax benefits of using retirement accounts too. Perhaps starting a Backdoor Roth IRA and investing it into index funds each year in addition to maxing out the 401(k) could help balance that out. Getting those student loans out of the way would also improve his cash flow.

Scenario Five: The Multi-Millionaire Entrepreneur

Wanda has done very well for herself. She has never been a fan of debt so she paid off her student loans quickly after school and bought appropriate amounts of life and disability insurance. She even paid off her house in just 6 or 7 years. They have ramped up the spending quite a bit, but she still saves about 20% of her gross a year and she has a million dollars spread across a portfolio of stock and bond index funds, both inside and outside retirement accounts. She also has a couple hundred thousand in real estate syndications that have been doing pretty well. She started a side business a few years ago and it really took off. She was able to cut back on her clinical work and her husband has quit his job and is now staying home with their two kids and helping out in the business where he can. She recently got a buy-out offer for the side business for $3 Million and is having trouble deciding what to do. What risks is she running?

1. Market risk
2. Interest rate risk
3. Inflation risk
4. Risk of running out of money due to inadequate returns
5. Risk of disability
6. Risk of death
7. Leverage risk
8. Small business/entrepreneur risk

Entrepreneurial Risk

Yes, she has some market risk, and probably even a little inflation risk. But it sounds like those are under control and well-managed risks. The real risk here is entrepreneur risk. Maybe the buyout offer is contingent on her sticking around for 3 or 4 more years in the business. She doesn’t really want to sell as she enjoys it, but 2/3 of their net worth is now tied up in a single business in a risky industry. At this point, a big part of their income and financial lives are tied to the business. She might have trouble going back to full-time practice and her husband burned a few bridges when he left.

Protection Measures

What can they do to mitigate their entrepreneurial risk? There are a few options:

• Pull profits out of the business (rather than reinvesting them) as quickly as possible and invest it in stocks, bonds, and real estate. Once they are financially independent (FI) just from their investments, even if the business completely collapses they are still FI.
• Sell the business and take all that money off the table. This would make them FI, although it would crush their dreams of making the business even bigger and it would not nearly as much fun without the control they have enjoyed.
• Sell part of the business by bringing on some investors. Some of that money could be used to “take money off the table” while another chunk of it could be reinvested into the business.
• Buy some “key man” (? key woman) insurance in addition to her personal life insurance to further protect the business.
• Borrow against some of the assets in the business and invest that money into the stock, bond, and real estate portfolio.
• Restructure the business a bit to provide some asset protection for it from her clinical practice.
• Hire out some jobs in the business to allow her to pick up more clinical hours and diversify their income.

Luckily for Wanda, this is a great position to be in, but that doesn’t mean she can’t minimize her biggest risk by some combination of the above.

What do you think? What are your biggest risks right now? What are you doing to protect yourself from them? Comment below!